What you’ll learn to do: describe the role financial markets play in an economy
In any given period, some households, businesses and governments earn more income than they spend. What do they do with their savings? Usually, it doesn’t make sense to put savings under your mattress or bury them in your backyard. Neither of those options will help your savings grow.
Other households, businesses and governments spend more than they earn. Households borrow money for new homes and new cars. Businesses borrow money to finance new physical capital investments. Governments borrow money to finance budget deficits. Where can these households, businesses and governments find the money to finance their expenditures?
The answer to each of these questions is financial markets. Financial markets are where savers put their savings to work and borrowers find funding to borrow. In this section, we will provide an overview of financial markets to provide context for the subsequent discussion of money and the banking system.
- Describe financial markets and assets, including securities
In earlier modules, we observed that individuals can either consume or save their income. We also noted that business investment in physical capital is the primary way they grow. Where do individuals put their savings, and where do businesses obtain the funding for investment expenditure? The answer to both of these questions is financial markets.
United States’ households and businesses saved almost $2.9 trillion in 2012. Where did that savings go and what was it used for? Some of the savings ended up in banks, which in turn loaned the money to individuals or businesses that wanted to borrow money. Some was invested in private companies or loaned to government agencies that wanted to borrow money to raise funds for purposes like building roads or mass transit. Some firms reinvested their savings in their own businesses.
Financial markets include the banking system, equity markets like the New York Stock Exchange, or the NASDAQ Stock Market, bond markets, commodity markets and more. In the 21st Century, financial markets are global, Americans put their savings into foreign as well as domestic bank accounts, foreign and domestic stocks and foreign and domestic bonds. All financial assets are called securities. Equities (i.e. stocks) give savers ownership in a company in return for dividends (a regular payment from the company) and/or capital gains (e.g. when you sell the stock at a profit). Bonds are a type of debt. All forms of debt are IOUs, where a saver lends money to a borrower in return for an interest payment.
Borrowing: Banks and Bonds
Businesses need money to operate and to grow. When a firm has a record of earning revenues, or better yet, of earning profits, it becomes possible for the firm to borrow money. Firms have two main borrowing methods: banks and bonds.
A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank (or banks) can take the firm to court and require it to sell its buildings or equipment to pay its debt.
Another source of financial capital is a bond. A bond is a financial contract like a loan, but with two additional properties: Typically, bond interest rates are lower than loan interest rates, and there are organized secondary markets for bonds, making them more liquid to bondholders than loans. Bonds are issued by major corporations and also by various levels of government. For example, cities borrow money by issuing municipal bonds, states borrow money by issuing state bonds, and the federal government borrows money when the U.S. Department of the Treasury issues Treasury bonds.
Watch the clip from this video to see an explanation of how the government could sell bonds in order to raise funds to build a new stadium.
A large company, for example, might issue bonds for $10 million. The firm promises to make interest payments at an annual rate of 8%, or $800,000 per year and then, after 10 years, will repay the $10 million it originally borrowed.
Treasury Bills, Notes and Bonds
When the U.S. federal government runs a deficit, it borrows the money from financial markets. The U.S. Treasury sells three types of debt: Treasury Bills, Treasury Notes and Treasury Bonds. Each of these debt instruments represents an IOU from the federal government. The difference between bills, notes and bonds is in their maturities: Bills are the shortest term debt with maturities less than one year. Notes have maturities between one and ten years. Bonds have maturities longer than ten years.
The other major way that firms can acquire financial capital is by selling shares of stock. Stock represents ownership in a firm, or more precisely, ownership in a corporation. Stockholders have limited liability for the corporation’s debts, but they share in its profits (or losses). When a corporation sells stock, it is called an Initial Public Offering, and the money goes to the corporation. Most purchases of stock, though, are sold in stock exchanges which means that they are sold by previous investors in the company to new investors in the company. The money goes to the previous investors, not the corporation. Either way, a stockholder earns income in the form of dividends (regular payments from the corporation) and/or capital gains (when one sells the stock at a higher price than when one purchased it). Note that it is also possible that a stockholder can suffer a capital loss, if the price of the stock when sold is less than the price when it was purchased. Thus, while the potential benefits of stock ownership are unlimited, there is a risk of losing some or all of what was invested.
Watch the clip for a brief introduction and explanation of stock markets.
- short term (less than one year) debt instruments
- long term (greater than 10 year) debt instruments
- debt instruments:
- equities or stocks:
- Ownership in a private company (unlike debt which conveys no ownership)
- financial markets:
- initial public offering (IPO):
- original sale of stock by a corporation
- intermediate term (1-10 year) debt instruments
- synonym for financial assets